FIFTH EDITION
STOCKS
for the
LONG
RUN
THE DEFINITIVE GUIDE TO FINANCIAL MARKET RETURNS & LONG-TERM INVESTMENT STRATEGIES
JEREMY J. SIEGEL Russell E. Palmer Professor ofFinande The Wharton School University of Pennsylvania
Mc Graw Hill Education New York Chicago San Francisco Athens London Madrid Mexico City Milan New Delhi Singapore Sydney Toronto CONTENTS
Foreword xvii Preface xix Acknowledgments xxiii
PARTI STOCK RETURNS: PAST, PRESENT, AND FUTURE
Chapter 1 The Case for Equity Historical Facts and Media Fiction 3 "Everybody Ought to Be Rieh" 3 Asset Returns Since 1802 5 Historical Perspectives on Stocks as Investments 7 The Influence of Smith's Work 8 Common Stock Theory of Investment 8 The Market Peak 9 Irving Fisher's "Permanently High Plateau" 9 A Radical Shift in Sentiment 10 The Postcrash View of Stock Returns 11 The Great Bull Market of 1982-2000 12 Warnings of Overvaluation 14 The Late Stage ofthe Great Bull Market, 1997-2000 15 The Top of the Market 16 The Tech Bubble Bursts 16
V CONTENTS viii
Risk and Holding Period 94 Standard Measures of Risk 97 Varying Correlation Between Stock and Bond Returns 99 Efficient Frontiers 101 Conclusion 102
Chapter 7 Stock Indexes Proxies for the Market 105 Market Averages 105 The Dow Jones Averages 106 Computation of the Dow Index 108 Long-Term Trends in the Dow Jones Industrial Average 108 Beware the Use of Trendlines to Predict Future Returns 109 Value-Weighted Indexes 110 Standard & Poor 's Index 110 Nasdaq Index III Other Stock Indexes: The Center for Research in Security Prices 113 Return Biases in Stock Indexes 113 Appendix: What Happened to the Original 12 Dow Industriais? 115
Chapter 8 • The S&P 500 Index More Than a Half Century of U.S. Corporate History 119 Sector Rotation in the S&P 500 Index 120 Top-Performing Firms 126 How Bad News for the Firm Becomes Good News for Investors 128 Top-Performing Survivor Firms 128 Other Firms That Turned Golden 129 Outperformance of Original S&P 500 Firms 130 Conclusion 131
Chapter 9 The Impact of Taxes on Stock and Bond Returns Stocks Have the Edge 133 Historical Taxes on Income and Capital Gains 133 CONTENTS ix
Before- and After-Tax Rates of Return 135 The Benefits of Deferring Capital Gains Taxes 135 Inflation and the Capital Gains Tax 137 Increasingly Favorable Tax Factors for Equities 139 Stocks or Bonds in Tax-Deferred Accounts? 140 Conclusion 141 Appendix: History of the Tax Code 141
Chapter 10 Sources of Shareholder Value Earnings and Dividends 143 Discounted Cash Flows 143 Sources of Shareholder Value 144 Historical Data on Dividends and Earnings Growth 145 The Gordon Dividend Growth Model of Stock Valuation 147 Discount Dividends, Not Earnings 149 Earnings Concepts 149 Earnings Reporting Methods 150 Operating Earnings and N1PA Profits 152 The Quarterly Earnings Report 154 Conclusion 155
Chapter 11 Yardsticks to Value the Stock Market 157 An Evil Omen Returns 157 Historical Yardsticks for Valuing the Market 159 Price/Earnings Ratio and the Earnings Yield 159 The Aggregation Bias 161 The Earnings Yield 161 The CAPE Ratio 162 The Fed Model, Earnings Yields, and Bond Yields 164 Corporate Profits and GDP 166 Book Value, Market Value, and Tobin's Q 166 Profit Margins 168 Factors That May Raise Future Valuation Ratios 169 A Fall in Transaction Costs 170 Lower Real Returns on Fixed-Income Assets 170 X CONTENTS
The Equity Risk Premium 171 Conclusion 172
Chapter 12 Outperforming the Market The Importance of Size, Dividend Yields, and Price/Earttings Ratios 173 Stocks That Outperform the Market 173 What Determines a Stock's Return? 175 Small-and Large-Cap Stocks 176 Trends in Small-Cap Stock Returns 177 Valuation: "Value" Stocks Off er Higher Returns Than "Growth" Stocks 179 Dividend Yields 179 Other Dividend-Yield Strategies 181 Price/Earnings Ratios 183 Price/Book Ratios 185 Combining Size and Valuation Criteria 186 Initial Public Offerings: The Disappointing Overall Returns on New Small-Cap Growth Companies 188 The Nature of Growth and Value Stocks 190 Explanations of Size and Valuation Effects 191 The Noisy Market Hypothesis 191 Liquidity Investing 192 Conclusion 193
Chapter 13 Global Investing 195 Foreign Investing and Economic Growth 196 Diversification in World Markets 198 International Stock Returns 199 The Japanese Market Bubble 199 Stock Risks 201 Should You Hedge Foreign Exchange Risk? 201 Diversification: Sector or Country? 202 Sector Allocation Around the World 203 Private and Public Capital 206 Conclusion 206 CONTENTS xi
PART III HOW THE ECONOMIC ENVIRONMENT IMPACTS STOCKS
Chapter 14 Gold, Monetary Policy, and Inflation 209 Money and Prices 210 The Gold Standard 213 The Establishment of the Federal Reserve 213 The Fall of the Gold Standard 214 Postdevaluation Monetary Policy 215 Postgold Monetary Policy 216 The Federal Reserve and Money Creation 217 How the Fed's Actions Affect Interest Rates 218 Stock Prices and Central Bank Policy 218 Stocks as Hedges Against Inflation 220 Why Stocks Fail as a Short-Term Inflation Hedge 223 Higher Interest Rates 223 Nonneutral Inflation: Supply-Side Effects 223 Taxes on Corporate Earnings 224 Inflationary Biases in Interest Costs 225 Capital Gains Taxes 226 Conclusion 226
Chapter 15 Stocks and the Business Cycle 229 Who Calls the Business Cycle? 230 Stock Returns Around Business Cycle Turning Points 233 Gains Through Timing the Business Cycle 235 How Hard Is It to Predict the Business Cycle? 236 Conclusion 238
Chapter 16 When World Events Impact Financial Markets 241 What Moves the Market? 243 Uncertainty and the Market 246 Demoerats and Republicans 247 xii CONTENTS
Stocks and War 250 Markets Düring the World Wars 252 Post-1945 Conflicts 253 Conclusion 255
Chapter 17 Stocks, Bonds, and the Flow of Economic Data 257 Economic Data and the Market 258 Principles of Market Reaction 258 Information Content of Data Releases 259 Economic Growth and Stock Prices 260 The Employment Report 261 The Cycle of Announcements 262 Inflation Reports 264 Core Inflation 265 Employment Costs 266 Impact on Financial Markets 266 Central Bank Policy 267 Conclusion 268
PART IV STOCK FLUCTUATIONS IN THE SHORT RUN
Chapter 18 Exchange-Traded Funds, Stock Index Futures, and Options 271 Exchange-Traded Funds 272 Stock Index Futures 273 Basics of the Futures Markets 276 Index Arbitrage 278 Predicting the New York Open with Globex Trading 279 Double and Triple Witching 280 Margin and Leverage 281 Tax Advantages of ETFS and Futures 282 Where to Put Your Indexed Investments: ETFS, Futures, or Index Mutual Funds? 282 Index Options 284 CONTENTS xiii
Buying Index Options 286 Selling Index Options 286 The Importance of Indexed Products 287
Chapter 19 Market Volatility 289 The Stock Market Crash of October 1987 291 The Causes of the October 1987 Crash 293 Exchange Rate Policies 293 The Futures Market 294 Circuit Breakers 296 Flash Crash—May 6,2010 297 The Nature of Market Volatility 300 Historical Trends of Stock Volatility 300 The Volatility Index 303 The Distribution of Large Daily Changes 305 The Economics of Market Volatility 307 The Significance of Market Volatility 308
Chapter 20 Technical Analysis and Investing with the Trend 311 The Nature of Technical Analysis 311 Charles Dow, Technical Analyst 312 The Randomness of Stock Prices 312 Simulations of Random Stock Prices 314 Trending Markets and Price Reversais 314 Moving Averages 316 Testing the Dow Jones Moving-Average Strategy 317 Back-Testing the 200-Day Moving Average 318 Avoiding Major Bear Markets 320 Distribution of Gains and Losses 321 Momentum Investing 322 Conclusion 323
Chapter 21 Calendar Anomalies 325 Seasonal Anomalies 326 xiv CONTENTS
The January Effect 326 Causes of the January Effect 328 The January Effect Weakened in Recent Years 329 Large Stock Monthly Returns 330 The September Effect 330 Other Seasonal Returns 334 Day-of-the-Week Effects 336 What's an Investor to Do? 337
Chapter 22 Behavioral Finance and the Psychology of Investing 339 The Technology Bubble, 1999 to 2001 340 Behavioral Finance 342 Fads, Social Dynamics, and Stock Bubbles 343 Excessive Trading, Overconßdence, and the Representative Bias 345 Prospect Theory, Loss Aversion, and the Decision to Hold on to Losing Trades 347 Rules for Avoiding Behavioral Traps 350 Myopie Eoss Aversion, Portfolio Monitoring, and the Equity Risk Premium 350 Contrarian Investing and Investor Sentiment: Strategies to Enhance Portfolio Returns 352 Out-of-Favor Stocks and the Dow 10 Strategy 354
PARTY BUILDING WEALTH THROUGH STOCKS
Chapter 23 Fund Performance, Indexing, and Beating the Market 357 The Performance of Equity Mutual Funds 358 Finding Skilied Money Managers 363 Persistence ofSuperior Returns 364 Reasons for Underperformance of Managed Money 365 A Little Learning Is a Dangerous Thing 365 Profiting from Informed Trading 366 How Costs Affect Returns 367 CONTENTS xv
The Increased Popularity of Passive Investing 367 The Pitfalls of Capitalization-Weighted Indexing 368 Fundamentally Weighted Versus Capitalization-Weighted Indexation 369 The History of Fundamentally Weighted Indexation 371 Conclusion 372
Chapter 24 Structuring a Portfolio for Long-Term Growth 373 Practical Aspects of Investing 373 Guides to Successful Investing 374 Implementing the Plan and the Role of an Investment Advisor 377 Concluding Comment 378
Notes 379
Index 405